The Anatomy of a Carry Trade Bubble

Last week I discussed some very important things, not the least of which was how to get rock hard abs. Equally as important is how asymmetry builds in nature and in financial markets.

Today I wanted to continue the discussion. A question posed by a reader prompted me to think about how to explain asymmetry in simple terms. Financial professionals, especially academics, have a tendency to make the simple sound as complicated as the internal workings of a viral disease. It needn’t be that difficult!

Here’s the comment and question posed by a reader:

“You guys completely nailed the lows in volatility last year and were positioned in the long dollar trade. I subscribe to a lot of publications and NOBODY I’ve read saw this, and then the repeated short renminbi call, I’m so grateful. Oh, meant to also deliver kudos since ages back when I first started reading you gents some two years ago re: your call on short yen at 77! I just wish I’d done something about it, but…hindsight right. I could have paid off my mortgage on that one.

I do have a question though. In your Dollar Bull Report you discuss the carry trade. How is it that the carry trade reached $9 trillion? Maybe not how actually, but just why really. What made it happen? Thanks for all you do. Amazing information, and all free!

– JD”

Why, thank you. You make me blush!

How the carry trade has reached such heights is an important topic since it goes to the heart of understanding how asymmetry builds. What is equally important to know is what to do with opportunities when they present themselves. Seeing a pretty girl is lovely and all, but getting her into… oh, never mind, it’s just better to know what to do, OK!

Let’s block and tackle the first one. Let me answer it with an example:

Buying a House

Imagine, if you will, aunt Claire. Aunt Claire is a real sweetie, a teetotaler, who lives in a gated community, puts her teeth in a cup beside her bed every night, and stands to attention when singing the national anthem.

Aunt Claire just bought a house. When she did so she took out a mortgage and as such is borrowing (shorting) dollars (or euros, francs, or any other currency). Aunt Claire is “long” the asset – the house.

Nobody including aunt Claire would buy a house if they believed it would go down in value relative to the currency being used to buy it with. The same is true in any carry trade anywhere in the world.

Let us assume that aunt Claire purchased this house as an investment in year one and it cost her $125,000. Let’s further assume that LVR is 80/20 and the cost of capital is 5% or $5,000 per year.

Year two rolls around and home prices have risen by 10%. Now, aunt Claire isn’t too bad at math. In her day she actually learned to add in her head without the use of a smart phone, and as such she quickly realises that investing in housing is the way she can finally get rich. She’s only got a few decades left before the arthritis really kicks in and nurses start taking away her nightly port shots. She’s keen to make the most of a good thing.

Aunt Claire focuses on the fact that in one year she added over $26,000 to her balance sheet. Since she only put down 20% of the purchase price her IRR is sitting at a whopping 58% and her cash-on-cash return is over 30% in just one year! She rushes out to get a new set of teeth and settles down to figuring out how much money she’ll be making next year. Smartly she begins to imagine what it would have looked like with more leverage. Aunt Claire is no different to hedge funds managing billions of dollars.

Aunt Claire enjoys a boom as house prices keep rising year after year. As prices keep rising so too aunt Claire decides to buy a few more houses, and so the leverage grows. More participants enter the market, all of them borrowing (short) dollars. Initially this makes sense since there is positive carry.

Let us now deal with the very simple way of determining whether the boom is produced as a result of productivity growth or if it indeed exceeds productivity growth. Where a divergence between the two opens up is where asymmetry lies.

Let’s look at this from a different perspective. Consider that asset prices are typically a multiple of revenue. In the case of house prices they are therefore priced at a multiple of cashflows. Cashflows come in terms of rent received or household incomes.

Let’s go back to Year 1 with aunt Claire.

House price $125,000

Cost of capital $5,000 (5%)

Income/rent $13,000 (10% gross yield)

P&L $8,000

Looks OK so far.

Now, let’s hop into our red hot time machine and race to year 10.

House price $324,218 (10% compounded annual growth)

Cost of capital $5,000 (still at 5%)

Income/rent has risen to $15,000, providing her now with a 4.6% gross yield

What just happened is that asset growth has exceeded productivity growth. Yields have collapsed from 10% to 4.6%. Productivity growth can be seen in incomes/rent earned and it’s clearly not kept pace with asset price growth. I’m being simplistic here and certainly there are any number of factors that could justify why this situation may make sense. Supply shortages, for example, can cause periodic distortions, and certainly in today’s world the largest of these distortions has been declining interest rates causing the cost of capital to plummet.

This is not dramatically different to what is taking place on a global scale when you hear about the carry trade. In the above example I can already hear many of you screaming at me: “But Chris, interest rates have fallen over the last 10 years so productivity growth doesn’t have to keep up with asset growth to the same extent.” Ah yes, and therein lies the seeds of the greatest asymmetry of all – global debt. A topic too detailed to cover today, but one which we cover in depth in our Global Debt report.

To Wrap It All Up…

The carry trade is the borrowing (shorting) of one currency in order to invest (go long) in either another currency or assets denominated in another currency. The world’s funding currencies are typically the Japanese yen, the US dollar and the Swiss franc.

The target currencies could theoretically be any currency providing a positive yield differential. The remnimbi has been a MASSIVE beneficiary of the USD/CNY carry, as detailed in our USD Bull Market report and multiple times on this blog.

As a side note: If you’ve not signed up for Real Vision TV, I strongly suggest doing so. What Raoul and Grant Williams have put together is fantastic – it’s basically CNBC for smart people. Go sign up already. It’s the cost of a few good bottles of wine and won’t leave you with the headache. And no, we have no financial relationship with them in case you’re wondering.

Back to the carry trade… What’s wrong with it?

Nothing! People everywhere are participating daily in some form of a carry trade. What is wrong is not the carry trade per se, but a situation where productivity growth cannot keep up with asset price growth. When that happens defaults begin to hit as aunt Claire realises that she can’t service her mortgages anymore, after she’s levered herself up with 10 houses and interest payments are getting tight. Then she has to pay back the money she borrowed.

This means she has to buy back dollars and in order to do so she’ll be selling houses. The problem is buyers aren’t interested in the houses offered at those prices and a very small move in the asset prices sets off a spiraling of selling houses to buy back dollars – an unwind of this particular carry trade.

And here’s the part that’s more fun than oil wrestling with super models. Everyone is selling assets (houses) for dollars which means the supply of dollars is insufficient to meet demand causing interest rates (which are a function of the demand and supply of dollars in the system) to rise, which in turn causes folks to reevaluate asset prices (houses) downward. Fun heh!

Asymmetry builds when market perceptions become divorced from the underlying. This is often reflected in deteriorating fundamentals on the back of rising asset prices. At the same time volatility is often found to be low or even decreasing as market participants, expecting a linear outcome, fail to see that risk is increasing and not decreasing.

Volatility is a great measure for what the market determines to be risky. Think of volatility like insurance premiums. High volatility equals greater risk and low volatility the opposite. Keep your eye on volatility as one means of determining where asymmetry may be lurking because that, my friends, is where to go hunting.

– Chris

“Bubbles arise if the price far exceeds the asset’s fundamental value, to the point that no plausible future income scenario can justify the price.” – Justin Fox